Corporate Inversions in the United States: A PrimerNovember 23, 2016
Corporate Desertion or Savvy Business Move?
At this point we've all heard about tax inversions: The process by which a company that's taxed heavily in its home country buys a smaller company headquartered in a country where the business taxes are considerably lower, then maintains that the newly amalgamated business is now officially headquartered in the low-tax country. Now domiciled in, say, Dublin, Ireland, with a corporate income tax rate of 12.5 percent or less, rather than Chicago, Illinois, with an effective US corporate income tax rate around 40 percent, the new entity enjoys greatly reduced income tax levels.
For example, US medical device manufacturer Medtronic purchased Irish company Covidien, and promptly declared Ireland to be Medtronic's domicile. Then there was US-based drug maker AbbVie, which acquired Ireland-based Shire and moved its tax base to the island of Jersey. And, in another high profile deal, American icon Burger King bought Canadian coffee and doughnuts chain Tim Horton so that Burger King could take advantage of Canada's lower tax rates. Even the failed attempts at tax inversion – Pfizer's bid to buy UK rival AstraZeneca springs to mind – are nothing if not audacious in the sheer scale of their ambitions.
And this is more common than you might think. In 2014, for instance, at least 15 of the top companies in the US held cash reserves of over USD800bn outside of the country. One of America's leading computer companies had well over USD50bn sitting in overseas accounts, while its main US rival was presiding over a USD75bn "nest egg." Meanwhile, another major American conglomerate had some USD100bn cash residing in various overseas tax havens. And so the list goes on – and grows larger by the year.
However, before we look at the pros and cons of this practice – and there are compelling and persuasive arguments both for and against tax inversions – we need to be clear about what inversions really are and how they work.
While no one has yet to offer a formal definition of a tax inversion, we can still say that tax inversions fall into one of two categories: pure tax inversions, which is what most people think of when they hear the term; and modest tax inversions, which, as the term suggests, is less far reaching in nature. In the former, "pure" transaction, one company purchases another just to achieve a tax inversion. That is, Company 1 acquires Company 2 simply to change its tax status. But Company 1 has no real interest in Company 2's products, its supply chain resources or its brand. Tax relief is all that Company 1 desires.
By contrast, in a modest tax inversion – "Tax Inversion Light" as one observer termed it – Company X buys Company Y for legitimate business reasons: It might be that together both companies are able to reduce costs and grow their market share. Or, one might want to eliminate the other as a competitor. Or, perhaps, together they want to expand and solidify their respective supply chains. Whatever the reason, the tax advantages that Company X might realize through its purchase of Company Y is merely an added bonus; it's not the main motivating factor behind the acquisition.
And, despite what some pundits and politicians might like to claim, there is actually no formal or legal difference between a normal cross-border merger and a tax inversion. In the case of most pure tax inversions virtually nothing changes: Company X (in Chicago, say) may be re-headquartered in Company Y's capital city (Dublin), but the CEO, the CFO, and the rest of the main management teams remain in Chicago.
Why So Many Tax Inversions And Why Now?
While it's true that we've been seeing larger numbers of tax inversions of late, they have actually been around for quite a while. According to Bloomberg QuickTake, "More than 50 US companies have reincorporated in low-tax countries since 1982, including more than 20 since 2012. And much of the data points to the fact that these may be 'pure' inversions, especially since most of the foreign companies being acquired are at least 75 percent smaller than the purchasing entity." 1
The more immediate trigger for this new wave of inversions is probably the fact that the US and Europe are now enjoying low interest rates, and that almost always leads to an increase in mergers and acquisitions. Some of this M&A activity may be occurring for reasons other than tax inversion, but easier access to credit only makes mergers more attractive and that may be incentive enough for more companies to seek out inversion possibilities.
But there are larger and more deeply embedded forces at work here. Prime among them is the US corporate income tax rate, which stands at a whopping 35 percent for Federal taxes plus another 5–10 percent for State income taxes or roughly 40–42 percent combined, making it the highest in the world. What's more, companies in the US also have to contend with the fact that unlike their counterparts in, say, Canada and the UK, they are required to pay that 40 percent rate on everything they earn, everywhere in the world.
Of course, defenders of the tax status quo will point to the fact that US companies can defer the bill on monies earned abroad until they repatriate said funds. But that is poor consolation for most companies as they still will need to accrue deferred income taxes on the deferred earnings, unless those earnings are going to be permanently reinvested outside the US.
It's also worth pointing out that the tax authorities in Canada and the UK only impose taxes on domestic income – not profits made abroad by the foreign subsidiaries of companies domiciled in other countries. One irony here is that a US firm making, say, guitars or duck lures, can end up paying more taxes than an identical US company owned by a foreign enterprise.
Another force at work here is more easily identifiable: Washington, the legislative and regulatory communities in equal measure. Given the political impasse that now seems to be the norm in Washington, the reluctance of either party, in either house, to engage in meaningful dialogue or make compromises may actually be encouraging companies to seek out inversion opportunities.
That may not seem to make sense, but in fact it does: despite the fact that legislators have been talking for some time now about enacting a complete ban on tax inversions, it never comes to a floor vote. Neither party seems willing to engage in the kind of Congressional "fire fight" that would inevitably ensue. Even ominous rumblings from the White House about possible executive orders limiting inversion deals consistently come to nothing. But it sure does make for good political fodder and press!
As a result it became abundantly clear to many in the US corporate community that in such a political climate there was little or no risk of regulatory backlash if they pursued their tax inversion agenda. Furthermore, they have an obligation to their shareholders to maximize shareholder value – and decreasing corporate taxes can significantly enhance value. Hence the upsurge in high-profile, multibillion dollar inversion deals.
Is Tax Reform The Answer?
As we pointed out earlier, the US has the highest corporate income tax rate in the world, and that, many agree, is why so many major companies are moving their executive operations abroad. Which begs the obvious question: Is the US tax code so onerous, so burdensome, that traditionally American companies are deserting the country simply because no one – Congress, the White House, the major Federal regulatory agencies, et al. – is prepared to make the necessary reforms and reduce the prevailing tax rates to reasonable levels?
Critics say that high tax rates notwithstanding, the current tax structure is so arcane, so convoluted and so riddled with loopholes that most US corporations never come close to paying anything like the full rate. But that certainly should not be a reason for inaction. Another irony here is that practically everyone – politicians, regulators, economists, and, of course, business people – agree that the tax code as it stands is not just flawed, but broken, and should be fixed.
But that's where agreement ends. None of the major players in this drama seem to agree upon what, exactly, should change. It's one thing to talk about "loopholes," but it's another matter entirely to agree upon which loopholes should be closed. After all, one person's loophole may well be another's legitimate tax break!
But are US corporations really deserting the country en masse? In point of fact, no. Companies that elect to exercise their tax inversion rights do not, as we pointed out earlier, actually move all their operations, or their management teams, offshore.
So are these companies what President Obama called "corporate deserters?" "I don't care if it's legal – it's wrong," said Obama in a 2014 speech at a Los Angeles college. "You don't get to choose the tax rate you pay. These companies shouldn't either. … You shouldn't get to call yourself an American company only when you want a handout from American taxpayers."
Nobel Prize-winning economist Paul Krugman agrees. As he wrote in one of his New York Times op-ed pieces:
"It's already illegal for a company to claim that its legal domicile is someplace where it has little real business … and tightening the criteria for declaring a company non-American could block many of the inversions now taking place. So is there any reason not to stop this gratuitous loss of revenue? No."
However, advocates for tax reform point to the fact that companies undergoing tax inversions don't do so lightly. In addition to the negative publicity such a move can elicit (witness the uproar when Burger King announced its purchase of the Tim Horton chain, or the reaction to the news that Perrigo had acquired Elan Ireland), the cost of the restructuring and the subsequent management complications can be daunting – and not a little inconvenient, even if management remains in the US.
But as John S. Barry of the Tax Foundation pointed out as far back as 2002, rather than castigating companies as unpatriotic tax dodgers:
"… policy makers should be looking at fundamental reform of the existing US corporate income tax code, which has become overly burdensome and mind-numbingly complex, thus penalizing American firms that compete in the global marketplace."
Even the courts ruled – over 80 years ago – that:
"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands." 5
For those who claim that cutting the corporate tax rate would shift the tax burden to the ordinary taxpayer, and that corporations would not reinvest the savings in the US, one merely has to ask: Why wouldn't they? Why make life complicated and management processes even more convoluted by becoming a "foreign" company? It's more likely that these corporations would pass some of the savings on to the consumer in a competitive marketplace. This makes small businesses that don't pay a corporate level tax nervous and keeps their lobbyists busy.
Ponder the burden to the consumer! A publicly traded corporation has a targeted return to its shareholders. Let's say that return is USD100 net of all expenses and taxes. If a country imposes an income tax, then the company must increase its prices to meet its target return passing the cost on to the consumer. If the tax rate is 20 percent then profits must be increased by 25 percent to cover the difference, and in addition sales tax or VAT tax is also inflated by 25 percent or, i.e., the consumer is paying sales tax or VAT on income taxes. If the tax rate is 40 percent, then profits must be increased by 66.67 percent to meet the target return. Welcome to the USA!
Writing in Politico Magazine, the dean of Columbia Business School and former chairman of the Council of Economic Advisers, R. Glenn Hubbard, observed:
"Reducing the US corporate tax rate – currently the highest in the industrial world – would increase investment, employment and wages, especially if financed in large part by broadening the corporate tax base. Economists once thought the tax burden was borne entirely by owners of capital, but many now see it as generating a significant burden on workers through lower wages. (By reducing investment, the tax reduces productivity and wages)."
Another and arguably better approach might be for the government to take an unbiased, non-partisan look at what, exactly, our taxes are used for. For example, USD223m for the infamous Alaskan "bridge to nowhere." But Congressional pork barrel projects like the Gravina Island Bridge pale into insignificance when compared with the projected trillion-dollar price tag for Lockheed Martin's much maligned – and still not operational – F-35 Joint Strike Fighter.
The list is virtually endless, but it does point to the fact that there is a serious misallocation of taxpayer funds that needs to be addressed – along with the arcane and outdated corporate tax code.
What You Need To Know
This is obviously a very complicated – and controversial – subject, so providing definitive answers to all the questions it raises is difficult.
Most companies, of course, have neither the resources nor the operational scale to even consider tax inversion possibilities. But there is, in fact, no official financial threshold a company must reach before it can consider the tax inversion route. In the end it comes down to costs and the real benefits a company might realize.
It almost goes without saying that before you and your company venture into tax inversion country that you should talk with qualified tax advisors and attorneys skilled in the field. You should exercise extreme caution as you carefully consider all the tax implications, including evaluating different ownership structures and exit strategies. For the unprepared making these sorts of crucial decisions, failure to consider all the consequences could be a costly mistake.
This article was originally published in the September 2016 edition of Global Tax Weekly:Corporate Inversions In The United States: A Primer by Curtis Best, a partner in our Tax practice.
About the Author
Curtis Best, CPA, is a Partner in the Tax Group at Marks Paneth. He is an international tax specialist with more than 20 years of public accounting experience who has served as a partner and tax manager in global professional services firms. Before joining Marks Paneth, Mr. Best was a partner in international tax and leader of his previous firm’s US Base Erosion and Profit Sharing (BEPS) team. His clients have included multinational companies, closely-held corporations with up to $1 billion in annual revenues, other middle-market business entities and related individuals.
Mr. Best specializes in global tax structures and optimization. His areas of focus include international tax structuring and minimization, mergers and acquisitions, intellectual property and software planning, permanent establishment planning, foreign tax credit planning, transfer pricing, cash repatriation, export incentives, and inbound and outbound tax planning and compliance. As a result of serving as a CFO/controller and mortgage consultant for a southeastern regional mortgage company, he developed strong expertise in financial reporting, strategic planning, tax and legal oversight, licensing and regulatory oversight in various states, mortgage servicing and foreclosures, investor relations and management of warehouse bank lines.
Mr. Best is licensed to practice as a certified public accountant (CPA) in New York State, North Carolina and South Carolina. He is a member of the American Institute of Certified Public Accountants (AICPA), the North Carolina Association of Certified Public Accountants (NCACPA), the South Carolina Association of Certified Public Accountants (SCACPA) and the International Fiscal Association.
He received his Bachelor of Science degree in Accounting at the University of North Carolina in Charlotte, and his Masters of Taxation at the University of South Carolina in Columbia. He is based in Marks Paneth’s midtown Manhattan headquarters and resides in New York City.